Stablecoins explained: three mechanisms, and how each has failed

Stablecoins exist because moving in and out of volatile assets through the banking system is slow and expensive. Rather than converting back to ordinary money, traders park value in a token that is supposed to stay at a dollar.

The word “stable” does a great deal of work in that sentence, and it is worth understanding what is actually holding the peg.

1. Fully reserved

How it works: a company issues tokens and holds matching reserves — cash and short-term government debt — redeeming tokens for dollars on demand.

What you are trusting: that the reserves exist, are genuinely liquid, and that the company will honour redemptions. This is a credit relationship with an issuer, not a property of the token.

How it has failed: reserved stablecoins have briefly traded below a dollar when confidence in the backing wavered — for instance when reserves were held at a bank that failed. They recovered, but holders who sold during the gap did not.

2. Over-collateralised

How it works: users lock crypto worth more than the stablecoins they mint — say $150 of ETH for $100 of stablecoin — with automatic liquidation if the collateral falls too far.

What you are trusting: the smart contracts, the price oracles feeding them, and that liquidations can actually execute during a crash.

How it has failed: during violent falls, network congestion has prevented liquidations from processing in time, leaving positions under-collateralised. The mechanism depends on the chain working precisely when everyone is using it hardest.

3. Algorithmic

How it works: the peg is maintained by supply mechanics — typically minting and burning a paired token — without adequate external backing.

What you are trusting: that market participants keep arbitraging the peg, which requires continued confidence in the paired token.

How it has failed: catastrophically. In 2022 a major algorithmic stablecoin lost its peg and collapsed to near zero within days, destroying tens of billions of dollars of value and taking several lenders with it. The failure mode is reflexive: confidence falls, the paired token falls, which reduces the backing, which reduces confidence further. Once that starts it does not stop.

What this means practically

• Holding a stablecoin is holding a claim on an issuer or a mechanism. It is not cash.
• Yield offered on stablecoin deposits is compensation for risk — someone is lending them out. Ask to whom.
• A stablecoin paying substantially more than others is not a better deal; it is a different risk.
• Diversifying across designs is more useful than diversifying across issuers of the same design.

If you are using stablecoins inside DeFi, read what is DeFi for how these compose — and how a peg failure cascades through everything built on it.